U.S. Auto Tariffs Would Deliver a Particularly Painful Sting to South Korea

Although South Korea renegotiated its free trade agreement with the United States this year, it failed to secure protection from threatened U.S. tariffs on automobiles.

While South Korean auto manufacturing on U.S. shores provides the sector with some insulation, with its reliance on the U.S. market, tariffs would have sweeping effects. However, South Korea's smaller market for imports means that it cannot hope to eliminate the trade deficit.

South Korea is likely to offer some sort of side agreement capping auto exports, while also dangling the prospect of stepping up its purchases of U.S. goods and its investment in the country.

Despite bending to U.S. pressure and agreeing both to revise the countries' free trade agreement and to accept export quotas on steel and aluminum, South Korea could still face tariffs on its vehicle exports to the United States. The government in Seoul is seeking ways to avoid the damage that tariffs could inflict on its auto manufacturing sector. But as U.S. President Donald Trump concentrates on strengthening U.S. manufacturing and rebalancing its trade relationships, the $22.6 billion trade deficit in goods between the two countries looms large. Although that deficit represents only a third of that between Japan and the United States and a small fraction of its $375 billion deficit with China, the South Korean trade imbalance has come under particular fire because of the role of automotive exports, which account for about 94 percent of that deficit.

The Big Picture

Washington is weighing whether to impose blanket 25 percent tariffs on all automotive imports in hopes of lowering the U.S. trade deficit and restoring American manufacturing prowess. South Korea's long-term reliance on access to the U.S. market, though, means that such measures would have a deep impact on the sector. As such, South Korea is likely to pursue some compromise that would avoid this blow.

Similar threats issued against Japan appeared to be geared toward goading Tokyo into officially engaging in free trade talks — a tactic that appears to have worked, at least for now. But with South Korea already having put the issue of revisions to the United States-Korea Free Trade Agreement (KORUS) to bed with no sign of U.S. auto tariff exemptions, the White House is clearly pushing it for a side agreement to address the auto issue. Given the small size of the South Korean auto market, attaining balanced auto trade is all but impossible, leaving South Korea with limited options as it tries to fend off those tariffs. It can emphasize the increasing share of manufacturing by its automakers on U.S. shores as well as its declining overall U.S. trade deficit over the past several years. But the White House likely won't be satisfied unless it obtains a deal enacting a quota for Korean auto exports to the United States or increasing Korean imports of U.S. goods.

Started From the Bottom

South Korea was part of the second Asian manufacturing wave — and a latecomer to both auto manufacturing and to supplying vehicles to the U.S. market. The growth of the South Korean auto sector dovetailed with the country's nearly three-decade transformation beginning in the early 1960s from a poor, developing nation to an industrial powerhouse. South Korea used Japanese automotive strength to build the foundation of its own auto industry, which first began producing vehicles using Japanese auto parts in 1962. By the mid-1970s, Korean manufacturers, benefiting from a monopoly over its protected domestic market, were able to switch to Korean-made components.

But while Japan's industry ascended to the status of top global auto exporter by 1974, South Korea remained a bit player. It was not until 1976 that South Korea exported even its first handful of vehicles — which were sent to Ecuador in exchange for fruit. Through the remainder of the 1970s, exports hovered around one-fifth of overall South Korean auto output. But South Korea's state backing of the sector through its family-run chaebol conglomerates, an extension of easy credit and strong protectionist measures incubated the industry, and production rose tenfold from 1974 to 1979.

In 1980, a sharp downturn in domestic demand followed South Korea's first recession since the 1950s, leaving its chaebol auto manufacturers (Hyundai, Daewoo and Kia) on the brink of collapse. Seoul responded by shifting the sector toward an export model — following Japan's lead a decade before. At the time, Japan had self-imposed restrictions on exports to the U.S. market, creating an opening in the low end of the market that South Korea could exploit. To take advantage, Seoul pumped hundreds of millions of dollars into expanding production capacity. In 1986, Hyundai debuted its first model to the U.S. market. By 1998, it ranked as the fourth-largest exporter of autos to the United States, behind Japan's Toyota, Nissan and Honda.

Concurrently, manufacturing automobiles for export became an even more important strategy for South Korea. In the early 1980s, one in four vehicles made in South Korea was destined for the export market; by 1988, two of every three were. And more than 80 percent of those vehicles went to the United States. The two other main Korean carmakers followed Hyundai into the U.S. market. Kia debuted in 1994. Daewoo made its first ill-fated attempt in 1987 by partnering with GM, but made a second run in 1998. South Korea's reliance on the U.S. auto market became even more acute after the 1997 Asian financial crisis disrupted domestic Korean demand. Today, South Korea is the seventh biggest source of global auto exports, and its major automakers are all oriented around building cars for export. Hyundai, for example, ships 85 percent of its output overseas, and Kia sends 65 percent. The same holds true for jointly owned Korean companies: General Motors Korea sends 75 percent abroad; Renault Samsung 64 percent.

Auto manufacturing has become a crucial component of the South Korean economy, contributing an estimated 10 percent to its gross domestic product and, including related sectors, employing 1.83 million — nearly 5 percent of the working-age population. The U.S. market is key to its success. In 2017, South Korea was the fifth-largest source of auto exports to the United States, sending $14.8 billion worth of vehicles and $5.2 billion in auto parts. Those goods accounted for 7 percent of total U.S. auto imports. Of South Korea's $62 billion in total vehicle and parts exports in 2017, 32 percent went to the U.S. market. The European Union was its second-largest export destination, absorbing nearly 20 percent of output.

Resisting the Pressure?

To a degree, South Korea (like Japan) has some insulation from U.S. tariff pressure. A large proportion of production by Hyundai and Kia, its two top automakers, is located on U.S. shores; both have opened U.S. production plants in the past decade. In 2017, Hyundai produced 328,400 units in the United States, accounting for about half of its total sold in America; Kia's 293,800 U.S.-produced units represented 64 percent of its U.S. sales. Kia has a further production capacity of 300,000 units in Mexico, under the newly revamped North American free trade agreement, now known as the United States-Mexico-Canada Agreement (USMCA). However, even substantial production on U.S. shores will not prevent South Korea from losing market share if the threatened tariffs take effect — which still would impact models manufactured largely in South Korea.

The high share of its auto sales in the U.S. market has created vulnerabilities for South Korea's manufacturers for now. However, Korea is expanding its presence in other markets. Its 2017, sales in the European Union totaled nearly 1 million, and in China, 1.15 million. Korean automakers have built up the capacity to annually produce 2.1 million vehicles — many for the Chinese market but also for export to elsewhere, including Southeast Asia. And, even as auto sales level off in the United States, China's market continues to grow at a healthy clip. Furthermore, South Korea has also expressed interest in joining the Comprehensive and Progressive Trans-Pacific Partnership (CPTPP) once guidelines for new members are outlined in the coming months.

The relatively small size of the South Korean auto market would make it difficult to increase U.S. auto imports as a way to lower its trade deficit. In 2017, South Korea imported $15.7 billion in vehicles and parts, 13 percent coming from U.S. automakers — on par with those from Japan and only one-third as much as those from Germany. In fact, 85 percent of South Korean new vehicle purchases in 2016 were domestic, with U.S. brands accounting for only 1 percent of the total. South Korea's auto sector is also greatly consolidated — with the Hyundai and Kia brands accounting for 73 percent of domestic production.

Even this relatively small proportion of U.S. cars in South Korea is a big improvement to years past. In the late 1980s, at the height of South Korean auto protectionism, 99 percent of cars on South Korean roads were domestically produced. The reduction of trade barriers through the 1990s opened up the market more. With the implementation of KORUS in 2013, tariffs protecting the South Korean auto sector dropped from 8 percent to 4 percent, then to zero at the start of 2016. KORUS also chopped away at non-tariff barriers. The net result was that U.S. exports to South Korea tripled overall, and auto exports matched that rise. But this failed to substantially impact the trade deficit. Accompanying rises in foreign imports overall meant the U.S. share of the foreign car market remained at about 8 percent. The mid-2018 renegotiation of KORUS saw further easing of South Korean non-tariff barriers in emissions standards and parts and safety regulations, but these are unlikely to substantially shift the balance.

Instead, as with Japan, barring some shift in U.S. trade strategy, South Korea will likely be compelled to accept some limitations on its exports to U.S. markets. That said, Seoul could try to head off the tariff threat by offering to invest even more money in U.S. manufacturing facilities or to increase its purchases of U.S.-produced goods, such as liquefied natural gas.